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Surety Bonds In Plain English (Construction)

This article is an abridged version of Federal Publications February 1996 CONSTRU


CTION BRIEFINGS
entitled Surety Bond Basics, copyright 1996 by Federal Publications, Incorporate
d, written by Messrs.
Donohue and Thomas. A complimentary copy of the CONSTRUCTION BRIEFINGS may be ob
tained by
contacting our firm. Subscriptions to CONSTRUCTION BRIEFINGS are available from
Federal
Publications, Incorporated, 1120 20th Street, N.W., Washington, D.C. 20036. You
may call Federal
Publications at (202) 337-7000 or (800) 922-4330.
Most construction contractors are familiar with the process of obtaining surety
bonds, but they may not be
aware of the legal relationships bonds establish the relationships among the pri
ncipal (the contractor), the
obligee (usually the owner) and the surety. Contractors lawyers, on the other han
d, are aware of the rights
and the obligations of the principal, obligee, and surety, but they may lack pra
ctical knowledge about the
process of obtaining bonds. This article is directed to both contractors and the
ir lawyers. It explains in plain
English just when construction surety bonds are required on federal, state, and
private projects, and the
bonding requirements contained in widely used contract forms, including federal
government contracts, AIA
contract forms, and the AGC subcontract form.
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SOME SURETY BOND BASICS


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A surety bond is not an insurance policy. A surety bond is a guarantee, in which


the surety guarantees that
the contractor, called the principal in the bond, will perform the obligation stated
in the bond. For
example, the obligation stated in a bid bond is that the principal will honor its
bid; the obligation in a
performance bond is that the principal will complete the project; and the obligat
ion in a payment bond is
that the principal will properly pay subcontractors and suppliers. Bonds frequen
tly state, as a condition,
that if the principal fully performs the stated obligation, then the bond is voi
d; otherwise the bond remains in
full force and effect.
If the principal fails to perform the obligation stated in the bond, both the pr
incipal and the surety are liable
on the bond, and their liability is joint and several. That is, either the princip
al or surety or both may be
sued on the bond, and the entire liability may be collected from either the prin
cipal or the surety. The
amount in which a bond is issued is the penal sum, or the penalty amount, of the bon
d. Except in a very
limited set of circumstances, the penal sum or penalty amount is the upward limi
t of liability on the bond.
The person or firm to whom the principal and surety owe their obligation is call
ed the obligee. On bid
bonds, performance bonds, and payment bonds, the obligee is usually the owner. W
here a subcontractor
furnishes a bond, however, the obligee may be the owner or the general contracto
r or both. The people or
firms who are entitled to sue on a bond, sometimes called beneficiaries of the bon
d, are usually defined in
the language of the bond or in those state and federal statutes that require bon
ds on public projects.
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TYPES OF SURETY BONDS
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BID BONDS
A bid bond guarantees the owner that the principal will honor its bid and will s
ign all contract documents if
awarded the contract. The owner is the obligee and may sue the principal and the
surety to enforce the
bond. If the principal refuses to honor its bid, the principal and surety are li
able on the bond for any
additional costs the owner incurs in reletting the contract. This usually is the
difference in dollar amount
between the low bid and the second low bid. The penal sum of a bid bond often is
ten to twenty percent of
the bid amount.
PERFORMANCE BONDS
A performance bond guarantees the owner that the principal will complete the con
tract according to its
terms including price and time. The owner is the obligee of a performance bond,
and may sue the principal
and the surety on the bond. If the principal defaults, or is terminated for defa
ult by the owner, the owner
may call upon the surety to complete the contract. Many performance bonds give t
he surety three choices:
completing the contract itself through a completion contractor (taking up the co
ntract); selecting a new
contractor to contract directly with the owner; or allowing the owner to complet
e the work with the surety
paying the costs. The penal sum of the performance bond usually is the amount of
the prime construction
contract, and often is increased when change orders are issued. The penal sum in
the bond usually is the
upward limit of liability on a performance bond. However, if the surety chooses
to complete the work itself
through a completing contractor to take up the contract then the penal sum in th
e bond may not be the limit
of its liability. The surety may take the same risk as a contractor in performin
g the contract.
PAYMENT BONDS
A payment bond guarantees the owner that subcontractors and suppliers will be pa
id the monies that they
are due from the principal. The owner is the obligee; the beneficiaries of the bon
d are the subcontractors
and suppliers. Both the obligee and the beneficiaries may sue on the bond. An ow
ner benefits indirectly
from a payment bond in that the subcontractors and suppliers are assured of paym
ent and will continue
performance. On a private project, the owner may also benefit by providing subco
ntractors and suppliers a
substitute to mechanics liens. If the principal fails to pay the subcontractors o
r suppliers, they may collect
from the principal or surety under the payment bond, up to the penal sum of the
bond. Payments under the
bond will deplete the penal sum. The penal sum in a payment bond is often less t
han the total amount of
the prime contract, and is intended to cover anticipated subcontractor and suppl
ier costs.

. JW Surety Bonds offers performance bonds for small to large contractors throug
hout the country.
Get a free quote using our online applications.
. Bryant Surety Bonds provides free quotes for performance bonds based on person
al credit for
small contractors and competitive for medium to large contractors.

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SURETY BOND REQUIREMENTS ON FEDERAL PROJECTS


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MILLER ACT AND FAR REQUIREMENTS


The Miller Act, 40 U.S.C. §§ 270a-270f, provides that all federal construction contr
acts performed in the
United States must require the contractor to furnish a performance bond in an am
ount satisfactory to the
contracting officer; a payment bond in a penal sum of up to $2.5 million, and ot
her surety bonds as well. In
the Federal Acquisition Streamlining Act of 1994, Congress made the Miller Act i
napplicable to contracts
under $100,000, and directed agencies to develop alternatives to surety bonds fo
r contracts between
$25,000 and $100,000. These statutory requirements are implemented in FAR part 2
8, bonds and
insurance. You can get a good introduction to the language and purposes of suret
y bonds simply by
reading FAR part 28.
BID BONDS
A bid guarantee is required on federal projects whenever a performance bond and/
or a payment bond is
mandated. Bid guarantees usually are in the form of bid bonds, but on federal pr
ojects they may also be
submitted as a postal money order, certified check, cashier s check or an irrevoca
ble letter of credit. A bid
guarantee must be in an amount equal to at least twenty percent of the bid price
; the maximum amount is
$3 million. The standard solicitation provision requiring bid guarantees says th
at if the contractor awarded
the contract fails or refuses to execute all contractually required documents, t
he agency may terminate the
contract for default. In such a case, the agency will make a demand on the bid b
ond or bid guarantee to
offset the difference in price between that bid and the next lowest bid. Bid bon
ds and bid guarantees are
returned to unsuccessful bidders after bids are opened; bid guarantees are retur
ned to the successful
bidder after all contractually required documents and bonds are executed.
PERFORMANCE BONDS
As amended by the FASA, the Miller Act requires payment bonds and performance bo
nds for all federal
contracts over $100,000. The penal amount of the performance bond is generally o
ne hundred percent of
the contract amount, and the penal sum is generally increased for each change or
der. The surety is entitled
to receive information from the contracting officer concerning the progress of t
he work, payments, and
estimated percentages of completion whenever it so requests in writing. The form
of the Miller Act
performance bond is set out at FAR 53.301-25.
PAYMENT BONDS
Payment bonds are now required for all federal construction contracts over $100,
000. The penal amount of
the payment bond is required to be a maximum of $2.5 million where the contract
price is more than $5
million; for contracts less than $5 million, the penal sum of the payment bond i
s to be forty to fifty percent of
the contract price. Each solicitation must state that a payment bond and perform
ance bond are required,
the penal amount required for the bonds, and the deadline by which bonds must be
submitted after contract
award. The form for a Miller Act payment bond is at FAR 53.301-25-A. The bond fo
rm does not set out any
time limitations for claims against the bond. However, the Miller Act provides t
hat suits against a payment
bond must be brought within one year after the date on which the last of the lab
or was performed or
material was supplied. In addition, the Miller Act requires that second-tier sub
contractors and others who do
not have a direct contract with the prime contractor submit a written notice of
their claim to the prime
contractor with ninety days of the last date of their work on the project.
REQUIREMENTS FOR QUALIFIED SURETIES
Federal surety bond requirements may be met in three ways: surety bonds issued b
y an approved
corporate surety; surety bonds issued by an individual surety who pledges certai
n defined types of assets;
or by the contractor pledging assets directly. The third option is uncommon.
REQUIREMENTS FOR INDIVIDUAL SURETIES
Individuals may act as sureties to satisfy bonding requirements on federal proje
cts if they have certain
acceptable assets in the required amounts to support the bonds. Although federal
agencies probably would
prefer to deal only with approved corporate sureties, allowance for individual s
ureties may enhance
competition by allowing awards to contractors that might not otherwise qualify t
o obtain bonds from an
approved corporate surety.
To support bonds issued by individual sureties, agencies may only accept cash, r
eadily marketable assets,
or irrevocable letters of credit from a federally insured financial institution.
Acceptable assets include cash,
certificates of deposit or other cash equivalents; U.S. agency securities (value
d at current market value);
stocks and bonds traded on the New York, American and certain other exchanges, v
alued at ninety percent
of their current 52-week low price; real property owned outright in fee simple,
valued at one hundred
percent of its current tax assessment value; and irrevocable letters of credit i
ssued by federally insured
financial institutions. Examples of unacceptable assets are also listed in the r
egulations. Unacceptable
assets are those that may be difficult to liquidate (e.g., a life estate in real
property); are of uncertain or
greatly fluctuating value (e.g., jewelry); property commonly exempt from attachm
ent under state laws (e.g.,
the individual surety s home); or commonly pledged to others (e.g., plant and equi
pment). An individual
surety is required to submit an affidavit, in which the surety identifies the as
sets, the market value of the
assets, and all encumbrances on the assets. The affidavit must also identify all
other bonds issued by the
individual surety within the last three years.
TREASURY LIST OF APPROVED CORPORATE SURETIES
By far the most common means of satisfying federal bonding requirements is by a
bond issued by a
corporate surety. The Department of the Treasury maintains a list of corporate s
ureties approved to issue
bonds for federal projects, Treasury Department Circular 570. Copies may be obta
ined from the agency.
The circular also is posted in the Treasury s computerized bulletin board at (202)
874-6817, and on
Treasury s Web site at http://www.ustreas.gov/. Whenever a new corporate surety is
added to the approved
list, a notice is published in the Federal Register. Contracting officers are pr
ohibited from accepting surety
bonds issued by corporate sureties not listed in Treasury Circular 570. The circ
ular lists the name and
address of each approved surety and all states where each surety is licensed.
When approving corporate sureties, Treasury makes a determination as to the fina
ncial strength of the
surety, and sets an underwriting limit, commonly called a bonding limit. The bon
ding limit is also stated in
Circular 570. When an approved surety offers a bond on a federal project, the co
ntracting officer checks to
make sure that the surety has not exceeded the surety s bonding limit. Because of
these underwriting
limits, surety bonds on very large construction projects, valued in the hundreds
of millions of dollars,
frequently are issued by several different approved surety companies, acting as
co-sureties. The name of
each co-surety will appear on the bond, along with its individual limit of liabi
lity.
Another way surety companies can stay within their approved surety underwriting
limit, and spread their
risk, is to obtain coinsurance or reinsurance, in which they essentially obtain
a contract from another surety
company to cover part of their risk on the bond they have issued. When a surety
obtains reinsurance for
part of its risk under a Miller Act bond, it must submit to the contracting offi
cer a reinsurance agreement for
a Miller Act performance bond and a reinsurance agreement for a Miller Act payme
nt bond. The terms of
both reinsurance agreements are stipulated in the regulations.
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SURETY BOND REQUIREMENTS ON STATE PROJECTS- LITTLE MILLER ACTS


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Statutes in all fifty states and the District of Columbia require performance an
d payment bonds for state
government construction contracts. These state statutes often are called Little M
iller Acts because many
of them are modeled after the federal Miller Act. Useful information is availabl
e from the National
Association of Surety Bond Producers. A good discussion of these Little Miller A
cts is in Federal
Publication s CONSTRUCTION BRIEFING, Little Miller Acts. A fairly recent summary l
isting of these state
statutes, along with citations, is in Bednar, et al., CONSTRUCTION CONTRACTING,
George Washington
University (1991), at 1309a-1309r. We will not duplicate these discussions. Each
state licenses sureties to
issue bonds. The Little Miller Acts each require bonds by licensed sureties. You
can identify sureties
licensed in particular states by checking Circular 570 on the computer bulletin
board and at Treasury s
World Wide Web site.
SURETY BOND REQUIREMENTS IN PRIVATE CONSTRUCTION PROJECTS
There obviously is a great variation among private construction owners and proje
cts throughout the United
States. Performance bonds and payment bonds are required by owners for most larg
e construction
projects. If the owner elects to require surety bonds, major issues for the owne
r to decide during project
planning are:
WHAT BONDS SHOULD BE REQUIRED?
Performance bonds protect the owner from contractor default and delays, and thes
e are important for
commercial properties with fixed tenant availability dates. Payment bonds protec
t the property from
mechanics liens, which might otherwise interfere with sale or refinancing of the
property. Bid bonds, which
generally address only the price-spread between the low and next to lowest bid p
rice, serve a much
narrower purpose. However, because of the expectations and requirements of the b
id package, corporate
sureties generally will issue bid bonds only to contractors who qualify for perf
ormance and payments
bonds. Thus a requirement for a bid bond may help narrow the field of bidders to
only those firms who can
actually satisfy performance and payment bond requirements.
WHAT SURETY COMPANIES ARE ACCEPTABLE TO THE OWNER?
Since a surety bond essentially is a guarantee by the surety, the owner has an i
nterest in deciding which
sureties are acceptable. One means of identifying responsible sureties is to ref
er to the list of sureties
approved in Circular 570.
WHO PAYS THE BOND PREMIUM?
Of course, the owner eventually pays all costs anticipated in the contractor s bid
, whether the project is
fixed-price or is a cost-plus-fee arrangement. A private owner may want to provi
de separate reimbursement
for the contractor s bond premium cost when the bond is delivered to the owner. Th
is procedure ensures
that bonds actually are furnished.
SPECIFYING THE AMOUNT OF BONDS.
Premiums rise along with the penal sum of the bond, and the owner ultimately pay
s these costs in the
contract price. Nonetheless, the owner has an interest in setting the bond penal
sum high enough to
provide the desired protection to the project. A fairly good guideline for setti
ng penal sums is the FAR
requirement discussed hereinabove. The penal sum for the performance bond should
be one hundred
percent of the original contract price, and the penal sum should be increased fo
r each change order. The
payment bond should be fifty percent of the contract price up to some fairly lar
ge maximum penal sum.
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SURETY BOND PROVISIONS OF STANDARD FORM CONTRACTS


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Popular form contracts for private construction projects, those published by the
American Institute of
Architects (AIA) and the Associated General Contractors of America (AGC), leave
bonding requirements to
the choice of the parties. Thus these forms do not provide much guidance in deci
ding the issues we have
identified. The current AIA General Conditions merely provide that the owner may
require bonds elsewhere
in the contract documents and that the contractor must furnish copies of the bon
ds upon request to any
bond beneficiary (e.g., subcontractors or suppliers). AIA Document A-201 also pr
ovides that compensation
for construction change directives ordered by the owner shall include bond premi
ums for the extra work.
AIA s current owner-contractor agreement, AIA Document A-101, does not address sur
ety bonds at all.
AIA s contractor-subcontractor agreement, AIA Document A-401, addresses bonding re
quirements in
article 7 by leaving a blank area for the parties to add any bonding requirement
s.
The current AGC Standard Form for Construction Subcontract, also endorsed by the
American
Subcontractors Association and the Associated Specialty Contractors, addresses s
urety bonds in article 5.
Paragraph 5.1 provides that copies of the contractor s payment and performance bon
ds must be furnished
to a subcontractor on request. Paragraph 5.2, Subcontractor Bonds, provides that i
f bonds are required
from the subcontractor, the subcontractor shall be reimbursed for surety bond pr
emiums in the first
progress payment. Performance and payment bonds must be in the full amount of th
e subcontract price,
unless otherwise stated.
PROVISIONS OF STANDARD AIA BOND FORMS
Private construction contracts rarely require particular bond language. Rather,
they usually require bonds in
a specified amount with a surety acceptable to the owner, general contractor or
other obligee. The AIA s
bond forms, AIA Documents A-311 and A-312, are popular and instructive; thus the
ir provisions merit a
brief discussion.
AIA s performance bond form, AIA Document 311, provides that the surety waives not
ice of change orders
and extensions of time. It says that the owner is the only person who can sue to
enforce the performance
bond, and that any such suit must be brought within two years from the date fina
l payment is due under the
contract. It also provides, if the owner declares the contractor in default, tha
t the surety shall either
complete the contract or, if the owner elects, shall obtain bids so that the own
er may contract directly with a
completion contractor with the surety providing funds sufficient for completion.

AIA s labor and material payment bond form, AIA Document A-311, is very similar to
the Miller Act payment
bond required for federal projects. It defines a claimant as a person or firm that
has a direct contract with
either the principal or a subcontractor to the principal. Thus in the typical ca
se where the principal is the
general contractor, claimants under AIA payment bonds are limited to subcontract
ors and suppliers who
furnish labor and materials directly to the general contractor or directly to a
subcontractor. Claimants are
entitled to sue on the bond if they have not been paid within ninety days after
the last day of their work on
the contract. Claimants that do not have a direct contract with the principal (e
.g., second-tier
subcontractors) must give a written notice to the owner and the surety within ni
nety days of the last day of
their work advising that the claimant has not been paid. Suits on the payment bo
nd must be brought within
one year of the principal s last day of work on the project. (This is different fr
om bonds under the Miller Act,
which requires that suits be filed within one year of the claimant s last day of w
ork on the project.) Suits
must be filed in a state or federal court for the county in which the project wa
s located.
AIA s combination performance bond and payment bond, AIA Document A-312, is simila
r to the separate
bonds described above, but this one adds some additional provisions. The perform
ance bond contains
requirements that the owner give the surety written notice before declaring the
contractor in default, and
provides for a meeting of the parties within fifteen days of that notice to disc
uss performance. The
performance bond also gives the surety the option of having its principal comple
te the project,
notwithstanding the default, if the owner consents. This probably would be done
with financing or other
assistance contributed by the surety. The payment bond in AIA Document A-312 req
uires that claimants
that do not have a direct contract with the principal take action in set time fr
ames. Such a claimant must
give written notice to the principal that it has not been paid; wait thirty days
for the principal s response, and
then notify the surety in writing that it intends to make a claim on the bond. I
t also requires the surety, within
forty-five days of such notice, to pay all undisputed amounts and to respond reg
arding any disputed
amounts.
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CONCLUSION
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If the terminology of construction surety bonds is confusing at first, you may w


ant to keep this guide as a
reference. Surety bonds are required for most large construction projects in the
United States and now
more frequently they are required in other countries. Our next article will revi
ew the process of obtaining
surety bonds, the choices contractors have among surety companies, and the agree
ments typically entered
into between contractors and sureties when construction surety bonds are issued.

GLOSSARY OF TERMS
BENEFICIARY:

A person who is entitled by law or bond language to claim against a bond even th
ough not specifically named as an Obliges.

BID BOND:

An obligation undertaken by a bidder promising that the bidder will, if awarded


the contract within the time stipulated, enter into
the contract and furnish the prescribed performance and payment bond's).

BOND:
An obligation undertaken by a third party promising to pay if a contractor does
not fulfill its valid obligations under a contract.
Some bonds may also promise that the Surety will perform if the contractor fails
to.

INDEMNITY BOND:

A bond which promises to reimburse an Obliges for loss incurred when a Principal
fails to perform its contract or (in some cases)
fails to pay for material, services or labor used in prosecution of the contract
.

MECHANIC S OR SUPPLIER S LIEN:


A right given by statue to certain persons - typically suppliers, laborers, arc
hitects, etc. - who perform services improving real
property. If they are unpaid, they may file a claim against the property and for
ce the owner to pay even if the owner has already
paid a prime contractor for their goods or service.

OBLIGES:

The named person to whom, under a bond, the promises of the Principal and the Su
rety run. For a prime contract performance
bond, the Obliges is usually the owner.

LICENSE BOND:

A bond required of all licensed contractors in certain states for the benefit of
specific persons designated by statue. Some of
these states allow a cash deposit with the state in lieu of a bond.

PAYMENT BOND:

A bond which promises to pay some or all of the persons who provide materials, l
abor, or services for prosecution of a contract.

PERFORMANCE BOND:

A bond which promises that the terms of a contract, or some of them, will be per
formed by the
Principal.

PENAL SUM:

The limit of the Surety s liability under its bond. The amount may be fixed by sta
tue (for license and permit bonds), by the initial
contract amount (for performance/payment bonds), or by some other means.

PRINCIPAL:

The bonded contractor, who has the primary responsibility for completing the obl
igations of a contract.

SURETY:

The third party (usually an insurance company) who promises to pay if the Princi
pal fails to fulfill its obligation under a contract.